Economic Times

Ian Kernohan

6 January 2015

Looking ahead over the next year, there are a number of key issues facing global markets. Some of these are perennial themes, such as the likely direction of US Federal Reserve (Fed) policy and China, while others such as Brexit, are relatively new.

We expect the Fed to follow through with more interest rate rises this year. The key debate centres on the pace of any increases, or indeed whether they end up performing a U-turn and cutting rates again. Given that they are seeking an end to “emergency policy”, rather than to slow the economy, we do not expect monetary tightening to proceed very rapidly. Our Fed Funds base case is flatter than the Federal Open Market Committee’s (FOMC) own “dot plot”, in part because we believe trend growth is lower than pre-crisis, and Fed action will be constrained when other central banks are easing. To embark on a more aggressive path of policy tightening when many US economic indicators are still tepid, and risks to the global economy remain, would risk overkill and a spike in long bond yields and mortgage rates. If we are wrong, we feel it is more likely that we underestimate the pace of Fed tightening, as economic growth surprises to the upside.

China concerns are an ever present discussion topic in markets. Fears often rise during the early part of the year, when reading the runes of economic data becomes even more problematic than usual, thanks to changes in the timing of the New Year shutdown. The “China is collapsing” thesis has never been our central case, although we expect these stories to resurface periodically. The current economic picture is complicated by the fact that some parts of the economy (industrial production) and some regions are slowing, while other parts of the economy (services) and the more diversified regions appear more resilient. Relatively high personal savings rates and cheaper energy are key support for household spending. In December, China launched the China Foreign Exchange Trading System (CFETS), with the explicit intention of moving market attention away from the bilateral USD/CNY cross, towards a basket of 13 currencies. Expect further weakness versus the US dollar.

It feels strange to turn more optimistic on the eurozone, since this has been one area of serial disappointment in recent years. The region is a major beneficiary of the shift in the terms of trade between energy producers and consumers, and is the one major economy where we have upgraded our GDP growth forecast over the past 12 months. The latest Purchasing Managers’ Indices (PMIs) point to continued momentum in growth, with little evidence of a drag from uncertainty around Greek debt negotiations during the summer, or the weakness of some Emerging Market economies. We expect overall activity in 2016 to be supported by cheaper energy, improved credit conditions, fading austerity, European Central Bank (ECB) asset purchases and past depreciation in the euro. Since the majority of economists remain cautious in predicting anything more than pedestrian GDP growth of c.1.5%, we think there is upside risk to consensus forecasts. With core inflation so low however, we think ECB tapering is a tail risk, rather than a central case.

On Brexit, the major lesson from the Scottish Independence vote in 2014, is that fear of the unknown will probably result in a vote to remain in the EU. Opinion remains volatile on this issue however, and there are bound to be periods when the vote looks to be a much closer call. This will create volatility in financial markets and not just in sterling markets, since Brexit will open up the whole question of European unity and a time when the concept of a borderless Europe is under pressure.

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